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Family Finance
Christopher Kobrak
To cite this version:
Christopher Kobrak. Family Finance: Value Creation and the democratization of cross-border gover- nance. 2008. �hal-00287770�
Working Paper: April 2008
Not to be cited without permission of the author.
Family Finance:
Value Creation and the democratization of cross-border governance
Professor Christopher Kobrak, ESCP-EAP, European School of Management, Paris Abstract: As Mira Wilkins has argued, there is a curious disconnect between business and financial history. (Wilkins, 2003) Whereas business history literature has rediscovered the importance of family business in many countries and in many sectors of contemporary commercial life, for example, little has been written about family banking as an alternative to joint-stock, management-run financial institutions. This lacuna is odd for many reasons. First, family banking is one of the best-known examples of family business in history. Second, family banks once played a much greater role in international investment banking than it does today. Third, some family financial institutions are still active (dominant) in certain market segments and countries. This paper will focus on how, when and why family banking lost its position in international (multinational) banking during the first few decades of the 20th century. Although political upheaval and a widespread movement to reduce the power of private financial institutions undermined their businesses, family banks suffered, too, from America’s maturing as a financial center. I will argue that this shift is connected with the increased importance of American markets and financial regulations, which, in the 1930s, deliberately steered financial transactions away from private dealings and toward transparent impersonal exchanges and capital markets with new forms of aggregated capital and individual investors, in which private banks were ill-suited to manage or at the least for which they had no special competitive edge. Using concepts drawn from an earlier paper on family businesses and relying mostly on secondary sources, this paper will further argue that in markets or market segments, such as Leveraged Buyouts, where uncertainty forms a greater part of the transactional environment, family banking still plays a significant role.
I. Introduction.
Avoid litigation and political controversy, and always keep out of the public eye.
Cosimo Medici’s father’s deathbed advice to his son, quoted in Christopher Hibbert, The House of Medici, p. 41.
Family and financial capitalism proved to be transition stages in the evolution of the modern enterprise and of modern capitalism.
Alfred Chandler, “The United States: Seedbed of Managerial Capitalism,” in Managerial Hierarchies, p. 28.
This paper aims at bridging a gap among three academic literatures, which unfortunately have remained too distinct: family business studies, banking histories, and financial theory. It will not attempt to establish new ground in any of these areas, just to highlight some connections, from which all three might deepen their understanding of their slices of social phenomena. As Mira Wilkins has pointed out, a curious disconnect has existed between business history and financial history, for example, which leads to a failure to highlight parallel and separate trends in their development.1 During most of the second half of 20th century, for example, financial theory strove to emulate the techniques of natural science, failing to integrate the social component and institutional configurations in economic decisions.2 I want to stress that this is primarily about changes in transatlantic financing (primarily investment banking), not domestic or colonial, between the end of the 19th and the end of the 20th centuries. My aim here is to present some initial thoughts about the political, economic and attitudinal changes that form the context for the institutional transformation for dealing with market imperfections, especially to highlight some changes in the role of private banking in dealing with uncertainty. By evoking family banking and private equity, I hope to suggest some plausible causes for the changes in the relative strengths of private- versus publicly-owned institutions in this sector. In addition to bringing together strands of business history and financial theory, I also hope that the paper will make a contribution to a better understanding of how our own era’s brand of globalization differs from or resembles that which preceded World War I.
Whereas the degree of cross-border financial flows before 1914 – only surpassed by some measure in the last decade of the 20th century – is well documented, less attention is paid to how private institutions furthered those flows in a financial
environment which lacked integrated multinational financial institutions and much of the regulation investors view as commonplace today.3 The financial integration of the 19th century gave rise to a set of corporate governance issues and approaches from which we may still learn.4 Recent discussions about the evolution of corporate governance hardly address issues of cross-cultural control and the role of particular institutions in creating the trust necessary to allow huge international capital flows when public regulations was in still its infancy.5 During the pre-World War I period of globalization, an epoch which rivaled our own in the integration of markets, private institutions, often organized into formal and informal cross-border “clubs” dominated by family networks filled the regulatory “trust vacuum” and managed substantial risks. Moreover, what is often neglected in the literature is the degree to which some older forms of corporate governance hang on despite a new round of international convergence.6
Despite the importance of family banking to the development of modern capitalism and the great number of “biographies” of family bankers, the transformation of banking, especially international banking, from family- to managerially-dominated has played a relatively small role in discussions of the Chandlerian model and financial history. The overriding theme of most of the great histories of banking houses such as Morgan, Warburg, Rothschild, Baring and their key personalities seems to be that the glory days of these institutions are, so to speak, “Gone with the Wind.” 7 Many aspects of banking today could be portrayed as excellent examples of Chandler’s flow-through industries, which achieved a dominant position in many sectors by mastering the efficient transformation of uninterrupted, large-scale streams of inputs, the output of which was matched with high demand fostered by further investment in distribution.8
Although much has been written about the transformations in transportation and communication, which helped set the stage for the revolutions in manufacturing and distribution of goods and the switch from family- to management-run firms, similar narratives – perhaps equally incomplete accounts – for service sectors are less prevalent in the literature.9 Even those who record the powerful persistence of family business in many countries and sectors seem to be at a loss as to how to explain the phenomenon.10 In the recent literature that has re-interpreted Chandler’s somewhat one-sided, American- dominated account of the evolution of big business, family banking is hardly evoked.11
While Chandler’s well-known explanation of the decline of firms and even whole national economies as a the failure to shift from family to multidivisional managerial firms with dispersed shareholding has come in for a great of criticism – as with much of his own original work – most of his critics draw their examples from non-financial sectors.12
Much of this piece will focus on the role of family banks in the United States, but the great weight of these banks in international finance was not confined to American markets. To be sure, by the middle of the 19th century, joint-stock banks in many countries provided a great deal of competition to private banks by harnessing larger deposit bases and providing new services, forcing the private banks into many cooperative efforts. Nonetheless, well into the 20th century, joint-stock banks had difficulty in replicating the cross-border reach of family banks in the United States and other major economies.13 Many of the early “multinational” joint-stock English banks had only their headquarters in the U.K., with their operations in colonial or developing markets. Today many of those banks maintain integrated, transnational operations all over the world internalizing the relationships that were once integrated by families or networks of smaller institutions,14 but by some accounts, at least, current attempts of mixing the attributes of public and private banking in one institution are fraught with difficulties.15
American regulations especially, and the surge of economic activity there, provided the private banks with special challenges and opportunities.16 Even when the United States began to export more capital around the turn of the century and after World War I, it was the private, not joint-stock banks, which led the way in deal-making and to a lesser extent in distribution of new securities.17 Well into the 20th century, regulation and communication hampered most of the continental European joint-stock banks – such as Deutsche Bank and Crédit Lyonnais, the two largest by some measures at the turn of the century – in running comprehensive banking operations not only in New York but many other financial capitals, often pushing them into alliances with private as well as other banks.18 For example, neither had an office in the other’s country. Apart from London, in major markets, their direct involvement with cross-border investment banking and other financial activities relied to a large extent on agents and correspondent
relationships. These banks had enormous distribution capacity in their own markets but were short of reliable talent on the ground in many key markets to find and manage investment opportunities.19 By way of contrast, in 1900, from London and other financial capitals, without branches or subsidiaries, relying on family connections and correspondent bank relationships, family banks handled not only trade financing but also led the way in multinational lending. 20
A series of political decisions on both sides of the Atlantic to make finance more
“public” and more “democratic” shrank the opportunities of private bankers to manage capital, especially for cross-border projects, transferring much of their raison d’être to governments and large public institutions. Before World War I most countries shared a reliance on active stakeholder involvement in companies. Especially, when the suppliers and users of funds were separated by great distances, family banks offered a means of overcoming the geographic separation. In contrast, during much of the 20th century in most of the developed world, regulatory oversight, transparency, diversification and liquid markets displaced active investor management as the bulwark of corporate governance, a tendency that some regulators now regret. Despite a reduction in economic power, over the past 100 years, private and family financial institutions, however, have remained strong players in several important activities. In these activities, markets, regulators and investors, especially for those investors seeking “above average returns,” have not yet found convincing substitutes for the advantages of family-like intermediaries in analysis and monitoring of companies. Indeed, an argument could be made that only through their brand of close management can real economic profit be earned at all.21
Many explanations have been offered for the evolution of differences and similarities among countries in their methods of corporate control, as well as for the apparent worldwide ascent of what is often called the market-based mechanism of corporate governance. The evidence presented here tends to support the more political and cross-border investor explanations, but takes these explanations more broadly and over a longer period than is done typically in the literature.22 Whereas most explanations view political and cross-border investor factors as explanations for the development of
America’s once-unusual system and that system’s ability over the last few decades to produce a new convergence, I will argue that the much of the politics was a worldwide phenomenon, that cross-border influences on corporate governance predated the Bretton Woods Era, and that the transformation was accompanied in many aspects of finance by an institutional revolution. Nevertheless, in contrast to some of the literature on the history of corporate governance, which tends to emphasize discontinuities rather than the continuities in corporate governance practices, this paper tackles the question of how and why some institutions first flourished and then survived, indeed thrived in some activities, in the face of major structural changes in corporate governance regimes.
For hundreds of years up through out own period, well-informed and sophisticated private bankers profitably exploited market inefficiencies.23 Indeed, they seem at their best when markets are spooked and investors hesitant to risk funds, that is, where uncertainty is high. To be sure, families are not the only institutions that can marshal funds by instilling trust and convincing investors that they can deal with uncertainty. Some of the financial intermediaries described in this paper perform only some traditional banking functions.
The paper suggests that three intertwined developments in capital markets have tended to undermine the competitive advantage of private banks in some financial areas.
First, greater access to financial markets, which has democratized financing by increasing the number of transactions, and the size and standardization of financial markets, has also reduced or merely changed the needs for intermediation. Second, an increase in public oversight designed to a large extent to contribute transparency to markets has decreased the value for holding private information. Lastly, a theoretical approach to finance that has emphasized quantitative analysis has developed to explain and manage risk in this new environment. From the capital asset pricing to option pricing models, modern finance has attempted to price risk based on statistical estimations of volatility and rewards of assets. Approaches to decision making designed for passive investors, leaving active management to those inside companies who control real assets (the management of volatility and reward), these techniques are ways of looking at the world of finance geared to inform investors as to how much reward he or she can expect with a given level of volatility or how much volatility he or she will have to expect for a given level of
reward. It is not designed for active management of assets or for clients who want more than the “expected” return. I say that the three aspects are intertwined because it is hard to imagine modern capital markets without all three attributes together.
Although most modern finance is predicated on a belief in a high degree of capital market efficiency with a random succession of price movements around a predictable trend – that is, all relevant information about the value of a security is embedded in the price of that security – history teaches us that the degree of market efficiency varies over time. For markets to be efficient in this sense, it is often forgotten that investors must not only have easy access to it, they must also trust it when they get it. Establishing trust is not always easy, especially where regulation is weak or where there is little in the way of personal credibility. The improvements of market regulation and increases in the quantity and type of instruments contribute to modern finance’s focus on market or systematic risk – the volatility of any security’s movement that can be explained by the whole market – versus unique risk, any fluctuation that cannot be explained by market movements. The quantification of security fluctuation against the market and the building of efficient portfolios using historically-accumulated data of numerous like instances falls into the realm of risk; all other forms of risk are part of uncertainty.24 This approach to the risk of investing risk implies that the risk of individual securities not explained by market movements can be diversified away too easily for the market to reward taking them. But underlying all of this is the belief that virtually all relevant information is embedded in a security’s existing price and that the owner of the security has no appreciable impact on its value by virtue of his ownership and efforts. To effectively diversify, institutions must be sufficiently large and conduct many transactions to reduce the unit cost of each transaction and spread risk in many different baskets.25
By exploring both the economic contribution of family business and the evolution of capital markets and society, this paper addresses the strengths of family banking at the end of the 19th century and their diminished role at the end of the 20th. It will argue that the evolution of capital markets have evolved in such a way over the past 100 years so as to undermine family banks’ chief competitive advantage – their ability to manage various forms of uncertainty or unique risk. That is not to say that capital markets at the
beginning of the 20th century were not large and robust, even by early 21st century standards.26 Merely that in the absence of certain institutions and regulations, family firms played a huge role compared to today in their international integration because of the degree of unique risk for which there was little alternative but active management as a means of ensuring adequate rents to entice investors to place their funds in often distant, innovative ventures. Where the management of unique risk remains the best way of doing business, family banks have maintained a strong competitive position.
My paper is divided into three further sections. The first deals with the activities of family banks at the end of the 19th century and the regulator and technological environment, which gave them their competitive advantage. The second part will highlight the changes in markets that undermined family banking. The third will discuss some sectors in which family financial intermediaries have held their own at the end of the 20th century and will suggest some theoretical reasons for this persistence.
II. Competitive Advantages of Family Banking Circa 1900.27
Capital markets weren’t so advanced, and investors weren’t so numerous, sophisticated, or well-informed as today. A banker’s seal of approval ensured that firms would enjoy unimpeded access to capital at highly attractive rates.
Ron Chernow, The Death of the Banker, p. 28.
Few financial historians doubt that international finance was dominated through much of the 19th century by private banks.28 What is at issue is the nature of their strengths during the period, and the timing and causes of their decline. Although I have deliberately sought to avoid a precise date, I will argue that until the early 20th century family organization of private banks aided them in establishing reputations for picking and monitoring investments, and for establishing a cross-border presence that enhanced communication between potential users and suppliers of capital, a capacity that joint- stock financial intermediaries could only achieve in much of the world much later.
The title of this section is a little misleading. I have chosen to link ‘family’ and
‘banking’ for several reasons. First, even though many of their activities are better described by the more general term financial intermediary, these institutions were called
banks in 1900. Not all the private banks whose role in international finance I want to emphasize were family institutions, most of the important ones were. Moreover, their family ownership helps explain the competitive advantages of even the non-family owned banks, that is, the strong bonds of kinship or friendship that allowed these institutions to coordinate activities and engender trust over significant amounts of time, which otherwise would have been extremely difficult. Family banks were just one of the main vehicles for achieving this competitive advantage in what we call banking at the end of the 19th century. In the 21st century, ‘financial intermediary’ is probably a better term.29
Family banks had an enormous advantage in the arena of cross-border lending.
From ancient times well into the 20th century, family banks possessed essentially two characteristics that helped make them first movers in the field of international banking.
First, while establishing and controlling multinational (multicultural) structures was very tricky, they could establish multi-poled businesses held together by family ties. Second, while engendering trust across borders through legal or other means was in its infancy, they instilled confidence in their judgment because family loyalty implied long-term commitment and discretion. In addition to correspondent relationships, the family was able to establish a quasi-multinational structure. At a time when creating actual subsidiaries would have posed an obstacle to the very sort of transaction the family banks wanted to conduct, the family became a kind of “holding institution.”
Some of the oldest institutions whose name recognition has survived to the present day were family banks, which not only played important roles in the economic but also the political history of their day. According to at least one leading scholar in the field, a strong argument could be made that they “constituted the first multinational business firms.”30 The Medici and Fuggers are only the best known of hundreds of early modern banking and trading firms, which held deposits, made loans, dealt in bills of exchange (an Italian innovation), and changed money through a large “multinational”
branch network. As the first movers in the field, they were at the core of cross-cultural economic interaction and managerial innovation from the 14th through the 16th centuries and remained market leaders in many financial services well into the 20th century.31 But
as Giovanni Medici, father of the Great Cosimo, recognized, the family’s position was fragile.32
Family banking by some measures has not fared well over time. Like private banks in general, family banks in particular, no longer are central to investment banking.
Consider a few facts. Although we have no league tables for 1900, all accounts of investment banking activities in New York stress the names of many private banks; few joint-stock companies are mentioned, whereas today all the major investment banks are public companies.33 It is plain that for a great number of transactions and sorts of information, those who need to invest or access savings have a great many ways to by- pass private banks today which were unavailable 100 years ago. What is true for multinational investment banking is also true for many other banking services. While many family businesses have outlasted governments, nations, cities, and once-mighty corporations, there are only two family banks on the list of the world’s 100 oldest continuous family-owned firms. 34 Only three of the largest 250 family companies in the world are banks.35 Private banking in England peaked in the 1820s, but its decline was gradual and concentrated in domestic banking activities.36
Nonetheless, some family banks thrive and may still have social usefulness.37 As late as the 1970s, several private banks shared an important role as managers and co- managers of securities issues in the flourishing but nascent Eurobond market.38 Until very recently, a few private banks were still big players in investment banking, and many commercial banks have felt a need to acquire the aura of once having been family-run to enter this lucrative field. Even if Ron Chernow’s view that “financial dynasties” have receded “to the status of historic dinosaurs” is a bit exaggerated, in the area of cross- border issuances of securities there is no doubt.39 As with the loss of any specie, the passing away of these “dinosaurs” may have unforeseen economic ecological consequences, if I might continue with this paleontological metaphor. In the eyes of many, family firms in general still provide a source of economic and social value. It should not be forgotten that the earliest discussions of corporate governance issues took as their starting point the loss of property relationships inherent in family business, which Berle and Means saw, and other writers have since developed, as not only an economic cost but also as a political threat.40
Through most of recorded time, in contrast to our own, business has been conducted by or with the aid of religious institutions or families, or some combination of the two. These two institutions seemed to provide a necessary framework and solace for the commercial activities of early entrepreneurs, whose “animal spirits” must have been severely tested by a myriad of risks and obstacles nearly unimaginable to today’s
“Masters of the Universe.”41 For some, however, financial markets and managerial hierarchies serve to alleviate the need for trust, once provided by these older human institutions. Indeed, many scholars and practitioners of our age find the role of family in major business enterprises hard to imagine. As Harold James put it in a recent contribution:
The simple fact of the literal familiarity of capitalism perplexes many commentators, and many indeed wish to deny it. Conceiving of capitalism as a vast, inhuman process, based alternatively on swindle and exploitation, that dwarfs and destroys individuals, they cannot see that it has anything to do with the affection and emotional warmth of family life or any sense of personal responsibility.42
To understand the competitive economic and social advantages of family banks, it is necessary to go back to a time “far, far away,” in which there was no World Bank, no Federal Reserve in the U.S., no Securities Exchange Commission (SEC) requirements – indeed there was no SEC – phone and telegraph services were neither cheap, completely reliable, instantaneous, nor completely secure.43 Though large and even larger in some countries as a percentage of Gross Domestic Product in 1914 than they are today, capital markets were not nearly as deep and efficient as they are now, and the means for assessing and dividing risk were not nearly as well developed. Transactional costs were higher and derivative instruments nearly non-existent. Banking regulation and attitudes in the United States and other countries, at least, made cross-border financing in some respects harder and in others easier. For much of the 50 years that preceded World War I, national tensions were held in check, making truly multinational networks of independent organizations advantageous and feasible.44 The Bank of England served as the lender of last resort for club of Gold Standard countries, whose governments by and large upheld certain rules of the game regarding stability and convertibility, but much of
the regulatory and technological infrastructure that makes the nearly-instantaneous linking of national markets feasible was not in place. Without the shared values and ties of family businesses, the internalization of international business transactions was just beginning for public firms. Only recently could companies begin to structure themselves into multipoled, interlocking confederations – sometimes referred to as transnational firms – instead of the more rigid home office and foreign subsidiary configuration which was commonly adopted by multinational business firms from 1918 to 1990.45 Arguably banking was one of the last sectors to build transnational Behemoths.46
Yet long before the Industrial Revolution, private banking helped to integrate financial and trade transactions in Europe. Continental Europe was the birthplace of private (U.S. name) or merchant banking (European). Many of these financial intermediaries’ varied businesses grew out of trade transactions, trade financing, and foreign exchange dealings. Though some could trace their histories back to the Middle Ages, their number and activities blossomed in the 19th century. By the early 19th century, in addition to the most famous family, the Rothschilds from Frankfurt (relative late-comers), the Warburgs in Hamburg, Oppenheims in Cologne, the Mendelssohns and Bleichröders in Berlin, and several Huguenot families in the Rhineland had already established family banking businesses, some with international reach. Many of these had survived the vagaries of economic fluctuations, revolutions, political persecution and limits on family progeny during the past two centuries. Some of them were also intimately connected with the great political transformations in Germany.47
German regulations provided many opportunities for private banks. Nevertheless, for certain activities they were forced to band together to protect their interests or seek new markets, which sometimes allowed smaller banks “to fight above their weight.” In most German-speaking states banking activities were licensed, and even after the Reich was established, there were few restrictions on banks working together. Well before bank shares could be publicly traded on exchanges in these regions, private banks (family banks) applied for the privilege to engage in specified banking activities, such as lending and dealing in foreign exchange. These were granted for restricted periods and with limited liabilities for the owners up to the par value of stock.48 As a result, in Germany, during the 19th century, banking associations were very strong. Not only did they form
syndicates for the issuance of many securities, they also created joint ventures and long- term strategic alliances for many activities, especially foreign ones.49
Even in London, where a wide variety of financial institutions and services flourished, family banks played a substantial role in the economic life of the city.
Although the City of London was unquestionably the financial center of the world for the half century before World War I, it depended on family banks to do cross-border business beyond Great Britain’s own colonies. Family banks were the principal financial links between this trade center and the rest of the world. They served as guarantors of foreign and domestic businesses, who wanted to access the London market with their bills or who wanted to raise capital among English and other investors. Bills accepted this way became known as bank acceptances, and their issuers, acceptance houses.50 Specialized among banks “proper” that took deposits, they provided domestic short-term loans and cleared domestic transactions. Most foreign transactions – accepting bills of exchange and issuing foreign loans – outside of the orbit of English colonies were handled by merchant banks, which were predominantly family enterprises. Despite England’s relative industrial decline between 1870 and 1914 and the predominance of such family institutions, its banking activity, especially international banking, thrived. The City funneled billions of English capital to the rest of the world. Whereas domestic private banks disappeared almost completely before World War I, eclipsed by their joint stock competitors, international merchant banks continued to do well. While inland bills of exchange disappeared, international ones grew rapidly, making “the merchant banks a permanent and indispensable cog in the works of English banking.”51
Of the first Accepting House Committee, a group organized to insure liquidity for the system as World War I began, 12 of the 21 banks had reference to the family structure of the firm in the name (Sons or Brothers). Several of the others had started out as family businesses and still had strong family ties with other institutions – for example, Morgan, Grenfell & Co.52 Virtually all the largest, including Lazard, Barings, Rothschild, Hambro, and Morgan were family businesses linked to much of the rest of the world by “separate”
family firms in other countries. The Germans, mostly Jews, provided much of the core of foreign banking community. Like Stern and Co., they not only operated in continental
Europe with their related family but also with joint stock banks in the United States and other countries.53
In contrast to deposit banks, these institutions changed little during the decades before the Great War and jealously guarded their private and family structures. Few merged. Only two of the firms making up the Accepting House Committee were registered as limited companies, Baring Brothers and Wallace Brothers. In 1910, only 12 of all the 95 merchant banks in London were limited-liability companies. As Youssef Cassis put it, “The corollary of this private type of structure was that the business generally remained a family one.” 54 This was true of almost all merchant banks, except for some rare cases in which the family did not elect to send a family member to London.55 Even those were still family-run affairs, with their initial strength coming from the dispersion of family members in major centers of activity.
With few mergers, marriage remained the main method of combining interests and expanding the management pool. It was true, too, of bankers in joint-stock banks.
Cohesion of international private networks even among them rested on family relationships. Intermarriage was not systematic among all banking families, but it was within well-defined groups. Jewish and Quaker bankers and their female offspring tended to marry into the banking families of their co-religionists. Marriages brought in new blood and created “dynastic” alliances among these banks.56 In spite of this limit to growth, the international reach of these banks was enormous. In addition to unsecured securities and syndicate loans, which are not broken down by region, in 1910 nearly half of Hambro & Sons investments, for example, were in North America.57
The American financial scene was even more encouraging for family-styled banks. There were dozens. Many Jewish family banks on Wall Street, including Lehman Brothers, Hallgarten & Company, Speyer & Company, J.S. Bache & Company and Kuhn, Loeb & Co., played an important role in bringing to market both U.S. public and private securities. Many rich Jewish families, such as the Lewisohns and Guggenheims, who had made their wealth in other fields, set up banks downtown near Wall Street.58 Lacking a central bank and a strong commitment to the Gold Standard, America was prone to financial panics and periods of sharp booms and busts to a greater degree than western Europe. Foreign investors perceived more risk in the United States and required
a premium and direct oversight to invest there; family banks soothed the fears of foreign investors by managing their U.S. interests and also helped by mitigating the financial consequences of the periodic panics.
For much of the latter half of the 19th century, many private banks not only had the advantage of their family network, they also were relieved of some confining regulations and nasty competition. A complex mixture of federal and state law – mostly New York because of its importance – inhibited some of the international investment activity of American joint-stock banks. In the United States, national banks operated with relatively severe reserve and branching constraints. Before 1914, these restrictions even included an inability to deal in bank acceptances. By 1900 some American banks were approaching the size of their European rivals, but U.S. national banks had to work with private ones and form separate companies to deal with statutory limits on their activities. State banks were confined to the states in which they were licensed. Their size and regional connections limited public banks’ interest in and ability to conduct foreign business. In contrast, following Anglo-Saxon custom, private banks were unlicensed, requiring virtually only to hang out a shingle to at least start doing business. Success, however, relied on their reputation for integrity. Not until the very end of the century did national, joint-stock banks and trusts begin to acquire retail and corporate clientele, which gave them the financial muscle to compete with the “internationally-funded” private banks for international lending and other cross-border transactions. Even then, many of these national banks had large family sponsors, such as the Rockefellers.59 Before 1914, moreover, national banks could not open foreign branches and were restricted from engaging in some trade finance transactions. Foreign banks, for their part, were prohibited in some key states from maintaining offices that took deposits.60 As private banks were not technically foreign owned, this restriction did not apply.
In short, even though European public banks were well established in their home markets and many had large portfolio investments in the United States, virtually all the banks in the United States with strong European financial clout in 1900 were family banks, not joint-stock institutions.61 Even multinational British banks, which worked with foreign offices mostly in colonial regions, suffered from severe governance (control) problems.62
In general, business and banking were in some sense more personal in the 19th century than today. Relying more on character and integrity, bankers in some parts of the world preferred from their customers – and customers from their bankers – personal rather than institutional assurance. Although private bankers were no saints and at times destabilized rather than stabilized markets, they lived by strict codes, enforced by their informal association.63 Many banks relied on their own equity rather than on deposits and borrowings. Capital, especially domestically generated, was scarce (hard to come by, and expensive) in the developing economies of the 19th century; it was, in short, far less of a commodity than it is today. Financial institutions were reflections of, and at the disposal of, their directors. They behaved more as “investment clubs” for channeling funds into projects, as Naomi Lamoreaux writes. In her study of New England banking in the 19th century, she argues that this region was very similar to other parts of the world.64 Even the great money centers of the world functioned this way. Scores of banks operated around the turn of the century in this fashion: the Rothschild cousins, the Speyers, Seligman Brothers, to name just a few who served as lead deal makers and deal enforcers.
To illustrate the importance of and the competitive strengths in international banking of family firms in this context, I will draw on some aspects of the histories of the House of Morgan and the House of Warburg, one banking group of English origin, the other of German-Jewish. For lack of a better term, I will use the often-employed expression house to describe the complex and informal network that brought together the firms in different countries that made up the group of separate institutions. Given the subject of this paper, the term ‘house’ has a special significance. I will use some salient examples about each to show why family banking played such an important role in international banking.
The histories of two of the most important private banks show that they made substantial profits by linking investors, who had little regulatory assurance of protection of their interests, with sometimes risky and often distant projects. Before international rating agencies and electronic transfers, even simple payments were difficult. These family banks had a rather unique international span of trust, for which in 1900 there was no obvious substitute. Moreover, the number of investments and investors was not yet
large enough and the techniques lacking to systematically diversify risks. The limited and sometimes distant liability of joint-stock banks stood in great contrast to the unlimited, personal, and close-to-home liability of internationally-connected family banks in key markets. Even though many debt instruments were backed by real assets, there was little or no alternative to direct oversight of business that required close contact between managers and shareholders. With economies of scale in financial services more limited and many regulatory and technical obstacles thwarting internalization of cross- border tasks, family enterprises provided much of the same internalization which multinationals could only achieve later. These stories illustrate the role private banks played in investment bank, although they increasingly linked up with public banks for their mutual benefit. The stories also set the stage for their eventual decline, as governments increasingly took a dim view of the profits generated by private sources of information.
The House of Morgan.
Founded in 1838 by George Peabody, the bank reached its zenith under the leadership of the son of Peabody’s partner and successor, J. P. Morgan, Sr. (1837-1913) and his son, J. P. Morgan, Jr. (1867-1943). Sent to New York by Peabody and his father after several years of training and education in both Britain and the United States, J.P.
senior came to dominate American banking and capital flows from England to the United States in a way that no other individual or institution of the time or since has. Profiting from America’s thirst for capital in the last decades of the 19th century and Europe’s fears of American mismanagement and sloppy regulation, Morgan and his associates in the U.S. and Europe brokered numerous government financings, corporate restructurings, and new equity offerings that were marketed in most of the developed world. With Britain providing the largest share of foreign investment to the world’s fastest growing economy in the second half of the 19th century, maintaining offices in both London and New York was particularly important. Until the death of his father in 1893, the connection between the offices in New York (for many years, Drexel, Morgan & Co.) and London (J.S. Morgan & Co., later Morgan Grenfell) was the family bond of father
and son. In the absence of a Federal Reserve, the elder Morgan even stepped in to stabilize markets during times of panic, notably during the mid-1890s and in 1907.65
Banking then was in some ways broader and narrower than in our time. Our modern conception of retail banking with numerous branches and tellers’ windows hardly existed. Both the users and the providers of capital were far less numerous. They consisted primarily of governments, wealthy individuals, various sorts of commercial firms, and other financial institutions. The bank concentrated on large security offerings and trading foreign-exchange-related instruments, a much lower volume business then than now. Morgan used to boast that 96 of America’s 100 largest companies were his clients, many of whom would make pilgrimages to see the bank, not vice versa.66 But before many kinds of transactions became routine, regulations bred more specialized institutions and capital markets developed to allow potential clients direct access, banking services were more like those practiced by universal banks in their heyday. They not only provided various forms of capital, but also consulting, accounting and other services.67
Morgan was selling a service, his assurance that what he said about a security would come true. Clients expected him to take a direct interest in the affairs of the companies, whose securities he had encouraged them to buy. That is why they were with Morgan. He and his colleagues practiced a discreet style. Clients felt as if they were accepted into an aristocratic club. In the uncertain world of pre-1914 finance, in which few reliable and quick sources of information were available, distant investors wanted their man on the spot, someone whose name and reputation not only was solid but whose work and commitment were assured by the closest of all bonds. If bankers in the pre- 1914 period were masters of the economy, Morgan was truly “the lord of creation,”68 a position which the bank held even after World War I, amalgamation, and the increased size of commercial banks had driven many other family banks into mergers or out of business.
The bank became a powerhouse all over the world, but British and American financial ties were its special territory. By 1910, the house had equals for business in other parts of the world, but for American-British business, it had no rival. Not only did the bank have the advantage of father and son in London in New York, it cultivated a
reputation for integrity and trust. Investors and borrowers rarely saw each other.
Financial statements provided little reliable information. They had to rely on the implicit guarantee of their go-between, whose judgment and good character had to be of the highest order. Despite being burned by the failures of several American railroads, encouraged by the House of Morgan, English investors poured vast new sums not only into transportation companies but also into completely new ventures, such as electricity.
As the house grew, especially the London branch, it took on more experienced bankers, but the first lot were all connected by a family bond.69
A few transactions illustrate how Morgan did business and why his style of banking was so important. Morgan earned enormous profits by leading several securities issues designed to stabilize the American currency, but perhaps his greatest influence was in the transformation of the ownership structures of American corporations. Unwilling to take full responsibility without full authority, Morgan was the point person for many of the most important private transactions of the day, an activity that required being prepared to step in and actively manage companies.70 Investors from all over the world bought securities with promises of high profits based on the House of Morgan’s continued involvement with the companies. As entrepreneurs exited firms, distant shareholders understandably asked the question: Who would watch the managers and protect their interests, a question that continues to trouble the holders of dispersed equity?
As two experts noted about the syndication of the sale of $32.5 million in shares the railroad magnate William H. Vanderbilt wanted to sell:
Once again, the imprimatur of the investment banking intermediary implied a credit-screening process and a presumption of quality that carried the day. And both the celebrity and franchise value of the House of Morgan were further embellished.71
During the last quarter of the 19th century, Morgan played a key role in the development of new industries and the reorganization of established ones. His early support of Edison’s plans for electrification in the United States is well known. By the late 1880s, however, Morgan pulled back somewhat from financing and managing the Edison businesses, giving way to a mostly German syndicate of banks and electrical
companies put together by Deutsche Bank and led by its representative in the United States, Henry Villard. The Edison companies were consolidated and pushed forward with an aggressive development plan, which required a seemingly endless series of new funds. Morgan came to the view that the major firms in the field should be merged but under the leadership of Edison’s rival, Thomson-Houston and its president, Charles A.
Coffin. During the approximately two years Villard served as Edison General Electric’s president, investors grew uneasy about the new company’s capital requirements and inability to list on either the New York or Berlin stock exchanges. In this and other transactions, distant investors seemed incapable of controlling this visionary but roguish native German. Although Villard had long argued that consolidation in the sector was the only way of increasing profitability, Thomson-Houston, under the guidance of several private banks in the United States, hired sound management and became far more profitable than the Edison company. By 1892, the German investors seemed glad to be done with the Edison venture. Morgan took the lead in negotiating the terms of a merger between the companies. The Germans opted out of the Morgan-managed transaction, which seemed to favor the Thomson investors. The House of Morgan stayed close to the merged company, General Electric (GE), which grew into one of the most valuable firms in the world. Morgan was less active than some other bankers, but much of the board of the new GE was made up of private bankers – including two representatives of the House of Morgan – who played an active role in bailing out the company during the Panic of 1893.
His own very active financial involvement did not preclude Morgan from relying on experienced managers to run the businesses. With good managers on board, he did not generally dictate policy for the successful firms for which he had organized capital.72 But especially for capital intensive businesses, he and his colleagues stood ready to take a more active role and organize new capital, a commitment that helped attract investors for new sectors like electrification and for old ones like transportation. In times of trouble, which all too often beset the poorly regulated American economy, Morgan and his colleagues plunged in to save companies in financial distress.
Morgan and other private banks played an important governance role in the rail sector, which in 1885 still made up over 75% of all the stocks traded on the New York
Stock Exchange.73 Although public banks provided much of the financing by purchasing securities and more importantly by distributing them, private banks took the lead in managing ailing lines. Together with Deutsche Bank, Morgan spearheaded the reorganization and management of the Northern Pacific Railroad in 1893. Indeed, Edward Adams, who replaced Villard as Deutsche Bank’s representative, actually drafted much of the reorganization plan that brought the Northern Pacific out of its third bout of financial distress in 1896, and served as the president of the newly constituted board.
Like many lines, the Northern Pacific was beset by overcapacity, competition, and regulatory ambiguities. Like many of these lines, too, Morgan and other private banks mobilized international capital and took over many control tasks to ensure that the shareholders did not lose their pants with their shirts. Deutsche Bank was particularly important to this reorganization due to the high number of German investors, but most of the management tasks fell to the House of Morgan, which headed the Voting Trust established to oversee the company for five years after it came out of receivership.
Within two years, Adams was forced to withdraw from the board. Four of the five members of the voting trust were from private banking houses. With the great distance, Deutsche Bank managers, for example, could not attend many meetings in New York at which personnel, investment, and accounting decisions were made and in general had trouble, even through their representative, influencing events. Morgan and his associates were particularly active in the management of the line and the balancing of the interests of various stakeholders. By the time the Voting Trust was dissolved, the investors who knew enough to hang on for the volatile ride were amply rewarded for their patience. But with all the intrigues among the participants and ups and downs with the restructuring, an investor had to have an ‘in’ with the insiders to know when to get out.74
By the end of the 19th century, however, there were already some signs that Morgan’s influence was diminishing. As America’s dependence on foreign capital and Britain’s relative position as a provider of capital waned, so too did the value of his special position between the two markets. Americans became wealthier, both in amount and distribution of funds, and various forms of joint-stock institutions increased their share of investment activity. There were more depositors for national and state banks, more trust accounts, and more insurance policies, wealthy families like the Rockefellers
funneled much of their investment activity through joint-stock banks such as Chase.
Moreover, even as cries for better public regulation of the American financial system became louder, other private banks began to rival Morgan’s ability to entice new foreign capital and serve as a reliable go-between by actively monitoring investments. Between new regulations and competition, by the time of his death and succession by his son, J.P.
had lost much of his relative financial clout. This was a process that accelerated after World War I, as will be discussed in the next section.
The House of Warburg.
At the end of the 19th century, the House of Warburg was Morgan’s main rival in New York, surpassing even some of their more famous competitors, whose partner structure constrained growth. According to some accounts, towards the end of the 19th century, the Rothschilds’ inability to find a family member to go to New York and the house’s reliance on the Belmont family contributed to the family’s relative decline in the United States and the rest of the world. In addition, unlike some families such as the Rothschilds which bound their empire with bloodlines, the Warburgs used blood and marriage to create a kind of confederation of banking houses in most of the centers of world finance. It was the looser grouping than the Rothschilds’ that allowed the family to move into areas in which direct decedents and the Rothschilds dared not tread. The Warburgs had at least in relative terms longer success than the Rothschilds, but in the end, their position too was undermined by national hostilities and technology.
Forbidden to own land and carry on trades, like many Jews, in the 16th century, the Warburg family became “Court Jews” as lenders at interest and dealers in foreign exchange in the area between Frankfurt and Hamburg. From Hamburg in the 17th century the family interest moved to financial activities outside of what would become Germany. M.M. Warburg & Co. was a private bank deeply involved in trade financing.
Whenever the bank needed money, the men married into other wealthy Jewish families, which also served to create commercial ties with Russia, Hungary, and France. Like many other family businesses, the Warburgs suffered at times from a dearth of qualified, motivated sons; they, in contrast to many other family banks, sent out their daughters to bring back new capital and new partners.75
The Warburgs had the distinction of operating two of the leading banks in Germany and the United States. In the 19th century, Rosa, Malchen, and Moritz Warburg married heirs to some of the most important banking houses in Europe and the United States. Trained at the family and other private banks, the oldest son of Moritz and Charlotte (nèe Oppenheim), Max Warburg, by the beginning of the 20th century, was expanding the activities of the German office and his own reputation as one of Europe’s leading financiers. Both his brothers, Felix M. and Paul, married into the Kuhn Loeb firm, considered the most up-and-coming bank in New York around the turn of the century, second only to Morgan in power. Felix’s daughter married a Rothschild, his sister a Speyer. The house’s marital relationships gave it a rare advantage. It could team up in various countries with strong partners while using its own international network to coordinate business opportunities. There was no partnership agreement or need to be exclusive.
Although the House of Warburg was involved in the management of many companies on both sides of the Atlantic and helped organize many cross-border launches of securities, its story illustrates two important qualifications to the power of family banking at the end of the 19th and early part of the 20th . In their heyday, the Warburgs were more dependent than Morgan on joint-stock banks. They could make deals and monitor companies, but they needed more distribution. But by the first decade of the 20th century, even Morgan found himself working more closely with joint-stock banks and trusts, such as Bankers Trust, which he helped found, to distribute securities and for other purposes. Unlike Morgan, however, the House of Warburg was more involved with companies whose original owners remained very active managers. In contrast to the Edison companies or the Northern Pacific, there was less need for active management for many of the companies in which the House of Warburg had the greatest interest. Kuhn Loeb’s Jacob H. Schiff was an important personal and financial advisor to the Great Northern’s owner-manager James J. Hill. Although Hill needed someone like Schiff to control some of his entrepreneurial “animal instincts” and calm other investors, Hill was one of the most knowledgeable, disciplined railroad men in the business. With his own management skills and Schiff’s financial acumen, Hill’s line never got into the same
troubles as the Northern Pacific, its main competitor and for a while partner, which had led to the active bank management of the latter line.76
Max Warburg had a very similar relationship to Albert Ballin, managing director of the Hamburg-American Line (HAPAG). Ballin convinced a reluctant Warburg to join his Supervisory Board against the policy of the bank. With the Ballin-HAPAG involvement, Kuhn Loeb invested in the German firm and Warburg joined the boards of several other German companies, a role that tended to be more active than usual in the United States but was generally less intense than some of Morgan’s turnaround situations.77
Warburg family members were leaders of the banking community, who also occupied important political and social roles on both sides of the Atlantic. In the pre- World War I environment their visibility enhanced their national status as well as their membership in a kind of international network of like-minded financiers; after 1914, it hurt them as liberalism imploded. Despite its reputation as philanthropists in Germany and the United States, as national passions heated up, the family suffered large losses.
Although the “American branch” fared better, it too came under a great deal of political scrutiny. Paul was a brilliant monetary theorist, who helped with the creation of the U.S.
Federal Reserve in 1913. But as the New York Warburgs, along with other bankers of German origin (ironically mostly Jews), tried to gather support and funds for the German cause before America entered the war, they were heavily criticized even before the United States declared war on Germany. Simmering frictions between rival firms in New York exploded into vitriolic debates about patriotism. Otto Kahn, a naturalized German- American partner at Kuhn Loeb who had married a relative of the founders of the firm, witnessed the question of his citizenry and loyalty.78 Like other private bankers, such as Jack Morgan, Kahn became one of the main focal points of general attacks on the banking system and international finance in the 1930s. In Europe, Max Warburg helped negotiate the Versailles Treaty, for which he and others were branded traitors by many Germans. Even Max Warburg’s sense of German identity, his enthusiasm for German imperialism before World War I, and the Jewish-American banks’ general support of financing Germany during the First World War, did not prevent the Hamburg Warburgs’
firm’s Aryanization and the necessity for most of the family to flee Germany in the late
1930s. The international Warburg family even ran afoul of their co-religionists for their criticism of the state of Israel, which they considered a throwback to primitive nationalism.79
But politics was not the only development that impaired the competitive strengths of private banks. Even before international consensus and flows broke down in the summer of 1914, the laying of international cables and later the introduction of the phone and wireless services reduced the costs of acquiring information and the competitive advantage of having reliable, autonomous representatives on the ground for other private, family banks such as the Rothschilds and Speyers - shifting power from them to larger, join-stock institutions.80 Of the bank houses discussed here, Speyer was the oldest. As a banking business, it dated back to the Middle Ages, to a town 100 kilometers from Frankfurt whose name it also bore. In 1800, the family was reported to be richer than the Rothschilds. With a great deal of foresight, in 1837, in the wake of the collapse of America’s second central bank and the panic that ensued after the lapse of its charter, Philip Speyer opened an operation in New York to deal in foreign exchange and to trade European merchandise. The House of Speyer operated in London as Speyer Brothers, in New York as Speyer & Co., and in Frankfurt as Speyer-Ellisson. As one of the first European banks to be represented in New York, it played a leading role in financing the Civil War and turning New York into a leading financial center. Other family members joined Philip. Using the U.S. as a kind of staging area, before World War I, the house became particularly well known for financing Latin America and the Philippines, bringing millions of dollars in funds from Europe.81 As a private bank with close connections, it could work with joint-stock companies, performing services in New York such as discounting bills, taking deposits, and buying and holding securities, which banks like Deutsche Bank could not, while utilizing the larger banks’ greater fundraising capacities in their own markets. For 50 years, Deutsche Bank and Speyer, who were tied by a family relationship, cooperated in many ventures. Speyer’s ability to handle day-to- day transactions, give advice, and find deals to be placed in Germany aided Deutsche Bank’s business enormously.82
In 1934, the American Speyer bank closed its doors.83 The world was in a state of financial meltdown and its services, if desired at all, could be performed by others. To be
sure, Speyer’s fate might have been extreme, but most of the great private banks had suffered enormous decline. Many closed their doors or merged with other firms; some were absorbed into public firms. From 1914 to 1950, one of the great private banks of German and British origin, Schroders, saw its political loyalty questioned due to its
“German name” and its underwriting and trade financing profits oscillate and decline. By 1960, the bank had transformed itself into a public company.84 Somehow the strengths of family banking lost much of their luster or, worse still, became liabilities. The
“hereditary calling” of banking which emphasized “character and connections,” key components in the private banks’ ability to “divide and diminish risks,” had in times of crash and public outrage about insider information diminished their economic benefits and turned them, in the eyes of many, into pariahs and causes of social disintegration.85
III. Ideological, Regulatory and Market Turns: Revolutions in Savings, Investment and Expectations.
The separation of ownership and control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge and where many of the checks which formerly operated to limit the use of power disappear.
Berle and Means, The Modern Corporation & Private Property, p. 7.
This section is designed to highlight some of the factors that led to family banking’s relative decline in international banking. Although World War I played an enormous role, the shift cannot be attributed to one event or circumstance. Indeed some of the causes predated 1914 and some continued well into the second half of the 20th century. Moreover, the pace and kinds of changes differed to some extent from country to country and had ups and downs within the interwar period. But by World War II, family banks had lost much of their role in international finance. The story of how and why is remarkably the same in several large capital markets. In part, the relative decline can be attributed to the decrease in trade and an increase in capital market frictions, but this is only part of the story. Some of the frictions actually added to the importance of family banks. Although uncertainty helped private banks in the mid-20s establish themselves as the chief conduits of capital between Europe and America, the combination of chaos and increased government controls, which particularly characterized the early
